Ranting About Risk

Failure imparts more lessons than triumph in money management. Success too often breeds hubris and excess confidence; disappointment invites analysis and reflection about what went wrong, why it went wrong and how to make sure the same mistakes aren't repeated.

Progress in finance and economics, in other words, relies more on failure than success. The truism comes to mind after reading the "confessions" from a "risk manager at a large global bank" in the latest issue of The Economist.

Might progress one day come even before the trouble starts? Perhaps, although the problem is the nature of the beast. Risk is a slippery concept, in part because its preferred method of arrival is in the guise of sheep's clothing. As the anonymous confessor in The Economist relates, risk has a nasty habit of appearing when common sense suggests otherwise:

In January 2007 the world looked almost riskless... At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.

It was also a time ripe with peril. The fact that few could see it, including the professionals paid to do just that, is a potent reminder that staying vigilant on the risk management front is an ongoing chore, particularly when it seems that risk is nowhere in sight.

The notion of risk's invisibility crossed our mind back in January 2007, when we asked point blank: Is Volatility Set For A Comeback? The question, with the benefit of hindsight, looks prescient, although in truth it was merely a prudent question posed by an otherwise mortal observer of the financial scene. Nonetheless, as we all now recognize, asking if risk was underpriced in January 2007 was the equivalent of wondering in 2001 if $20-a-barrel oil was worth buying; or if stocks should be sold in March 2001.

Why, then, were so few asking such questions? The answer is no doubt tangled up in the fact that turning a profit was so easy. Today, by contrast, profits are hard to come by and risk is on every investor's lips. So it goes in finance: up is down, black is white, and common sense and forward thinking are as wispy as clouds on a windy day.

The good news is that there are countless ways to measure and analyze risk. Sometimes a given technique works, sometimes not. But rather than discourage strategic-minded investors, the weakness and limits of any one risk metric as a fail-safe tool should inspire us to routinely monitor several gauges.

That said, we like to keep a close eye on volatility as a starting point. To be precise, rolling 36-month standard deviations of trailing monthly total returns. (A recent survey of vol can be found here.)

No, volatility is no crystal ball into the future, and most of the time it's of little if any value. Indeed, its best clues spring from radically low or high volatility. Those signs are far more valuable about handicapping the future than the modest levels of vol that prevail most of the time. Thus, in early 2007, we thought maybe, just maybe, a change in the financial weather was coming. Timing, of course, was unknown, as always.

Volatility these days, by comparison, isn't all that helpful for peering into the future. Yes, vol is up from the 2006-2007 trough, but that's like saying the cats are more nervous now that one of their own got his tail caught under the rocker.

Risk management isn't getting any easier and arguably it's become a whole lot tougher compared with a year or so previous. Risk, on the other hand, still flows as easily as rivers after a spring rain.

That stirs some to think that risk is beyond us, outside of our control and in the fates of the financial gods. Acknowledging that no one can see the future, it's easy to think that we're left to invest as conditions of the moment suggest and take our lumps as they come. But it's a mistake to throw up one's hands and say that the future's unknown and so there's no point to risk management. The pain of financial history has taught us something after all.

That starts with the observation that there are always hints about the future, and monitoring vol is just one of the portals that dispense signs about what's coming. As the anonymous confessor in The Economist reminds: "No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly."

Ideally, risk management is practiced as a multi-faceted strategy, as we recently discussed. The value of having multiple choices in our risk toolbox helps reduce the chance of being led astray by the misfiring of any one signal.

Yes, even risk management is risky, which leads us to familiar terrain. Diversification, in other words, is still the only solution. True for pursuing returns, and true for monitoring, managing and otherwise keeping a lid on risk.

Comments

[Jackson Cash:]

I agree, however would emphasize that even after the subprime exposure "opps", risk is very much still underestimated. The opinion of this poster is that regulatory protectionism is removing or retarding the risk-transparency to the average individual with limited means to information. This is most notable with "bailouts", etc, which target one thing -- risk. We're all saddled with it, which is unfortunate in a [once] capitalist society.

2008 Aug 12 12:56 PM

[Duude:]

While I believe there will be a period of re-expanding of multiples on financial firms that were most vulnerable to the subprime mess, I think over the longer run we will see a trend to discounting these firms over the longer term. Their credibility is bleak regardless of any big upturn in earnings. Those same earnings will remain suspect and should always be. These firms have shown us their power to wipe out a decade of earnings in a year. Their short-sightedness is shockingly stupid. Bonuses must have long-term strings. The department of risk management must be elevated above the mailroom. All future bonus payouts must be approved by risk management with their own jobs at risk. Internal Whistleblowers must be given a free get out of jail card by corporate heads.

2008 Aug 12 01:37 PM

[BrianZach:]

The problem with risks management is that investors are human. It is easy to focus on risks after this financial crisis.

However, when there is another bull market, traders and financial institutions will slowly increase their risks without even realizing about it. As it gets easier and easier to make money, it starts getting harder and harder to imagine the possible risks, especially from events that never occurred in the past. Greed will run its course again.

2008 Aug 12 09:52 PM

[bearfund:]

Let's start with the fundamental assumption that everyone forgets: the maximum possible loss on any instrument is 100%. Not 20%. Not 45%. 100%. Always and without exception. Therefore, the greatest risks are disproportionately those that involve the greatest leverage, not those that involve the greatest likelihood of loss or likehood of total loss. People talk about black swans and fat tails; the real problem is not that these events happen more often than people think but the simple fact that they happen at all. Therefore if you want to manage risk, you have to manage leverage. Risk wasn't underpriced, leverage was. Why? Because money was cheap. The market has lost the power to price money; the laughably incompetent Fed does that now. Then when things go wrong, they bail you out. Why banks even bother employing risk managers is beyond me; there's no point. As long as your only risk is gross overuse of leverage, there is no risk, so gear up, baby. Gear up. In a free market, the company geared up 2x on a mix of investment-grade paper, equity, and a dash of speculative opportunism with a hefty chunk of gold sitting in the basement is infinitely less risky than one geared up 50x on Treasury-backed paper. And, curiously, the former has more upside and contributes far more to the real economy. But why take those risks when you can take risks that aren't with free money?

2008 Aug 12 11:30 PM

[bbzz24:]

it is blatantly clear from the quoted paragraph that his lad:
1. has no clue what economic cycles are;
2. cannot identify areas of above par growth relative to the whole market.
yet he is in charge of risk. you wonder why banks continue to write off assets 1.5 years after it all began (Feb 2007 was the first tectonic move in CDS).

those times he describes were of high yield bonds paying 1% premium over treasuries, 0.75% over GSE debt, 0.5-1% below standard libor tied loans. and all this seemed to make perfect sense to him. please disclose the name of that bank, it is a perfect shorting opportunity.

2008 Aug 13 02:16 AM